Can the

Fannie Mae

(FNM)

scandal now take its place as the Enron-sized debacle it long has been shaping up as?

Up till Wednesday, many on Wall Street and in Washington were quite willing to downplay a detailed report by Fannie's regulator that showed the company had used faulty accounting in a way that allowed it to keep billions of dollars of losses out of its income statement.

But Wednesday evening, the

Securities and Exchange Commission

, the stock market's main cop, gave Fannie's regulator its backing by saying that Fannie had violated accounting rules. The agency took particular issue with the way Fannie accounts for derivatives, which are financial instruments the company uses to insure itself against adverse movements in interest rates.

The SEC, speaking through its chief accountant, also told the government-sponsored mortgage giant to restate its financial reports. That's a deeply humiliating demand for Fannie CEO Franklin Raines, because he had fought the accounting charges and staunchly defended the integrity of Fannie's books before Congress in October.

The fact is, Fannie's dubious accounting allowed it to keep a stunning$9 billion worth of losses out of earnings, making a closely watched measure of regulatory capital look much stronger than it actually was.

Fannie will now face the prospect of having to quickly raise as much as $11 billion in fresh capital. It could do that by liquidating over $300 billion of mortgages or by issuing new stock. Neither option is good for Fannie's stock, which has stubbornly remained in the high $60s since the scathing Sept. 20 report from Fannie's regulator, the Office of Federal Housing Enterprise Oversight, or OFHEO. It slipped 5% early Thursday on news of the setback.

Turmoil

The $9 billion in losses that will need to be recognized are equivalent to over one-fourth of Fannie's core capital, and they far exceed the $7.9 billion Fannie earned last year. Any other financial company that incorrectly treated a similar level of losses could easily find itself under the control of regulators.

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However, the reason for the market has so far been ready to shrug offFannie's problems is the widespread belief that Fannie's government-sponsored status amounts to a government commitment to bail the company out if it gets into trouble. That implicit guarantee certainly exists, but it won't protect investors now that the SEC has so clearly damned Fannie's accounting.

Fannie, with over $1 trillion of assets, is going to be plunged into aturmoil and it will soon have to operate under much stricterregulation. The SEC's decision will make it very easy for theBush administration to get congressional backing for a package ofreforms for Fannie and the other government sponsored mortgage giant,

Freddie Mac

(FRE)

. Fannie had managed to mount a huge lobbying campaign to squash attempts during the first Bush term to legislate reforms.

The administration aims to have a bill moving through Congress by April, according to a person familiar with the administration's thinking.

And it will find a much more receptive environment. Following the SEC's opinion on Fannie, House Financial Committee Chairman Michael Oxley (R, Ohio) said Wednesday night that his committee wanted to work toward "sweeping legislative reform."

Investors shouldn't expect up-to-date financials for many months.

'Wheels of Justice'

There has always been a small cadre of Fannie skeptics, who oftenmanaged to get their arguments out despite the attempts of Wall Streetto defend the company. One of the leading Fannie critics, Lawrence Kamof Sonic Capital, said: "I commend the professional staff at OFHEO andthe SEC. The wheels of justice sometimes move slowly, but they move."(Sonic has sold Fannie shares short, meaning it will benefit from anydecline in their value.)

In addition, this column has

long warned investors that Fannie had big problems with its accounting and with its derivatives losses. It also highlighted the reckless and self-serving moves by the Raines-led management team.

Yet, despite the ugliness of the $9 billion of losses and the unmistakable frankness of the SEC's remarks, there will be many who will deny the Fannie scandal is as big as Enron's or WorldCom's. While it likely won't lead to the bankruptcy of Fannie, the scandal is as bad, and in some ways it is actually worse. Here's why.

Like Enron and WorldCom, Fannie was able to keep billions of dollars out of its income statement by failing to properly apply clear and easy-to-understand accounting rules. Fannie failed to comply with a derivatives accounting rule called FAS 133. That rules says that to keep losses on derivatives out of earnings (and instead store them on the balance sheet), a company must meet all sorts of stringent requirements to show the losses are more or less offset by gains elsewhere on the balance sheet. Fannie simply failed to show that its derivatives losses were offset by particular gains, according to OFHEO.

Just Like Enron

How on earth did a company with a triple-A credit rating (for how muchlonger?) and a solid reputation come to that level of alleged accounting abuse? The most likely answer is that Fannie never set out to properly apply FAS 133, which became effective in 2001. Fannie never hid its dislike of the rule and led a massive, and somewhat successful, corporate lobbying effort to modify it in the late '90s. Like Enron, Fannie appears to have thought it wasabove the rules.

In OFHEO's report, Fannie's chief accountant said:"We have several known departures from GAAP in our adoption of FAS 133. We have cleared those with our auditors." (GAAP stands for generally acceptedaccounting principles, which are the accounting rules that the SEC expects public companies to follow.) The executive, Jonathan Boyles, appears to be saying that Fannie knew it didn't apply FAS 133 properly and was OK with that.Enron took the same dismissive view of accounting guidelines, in its case for all sorts of off-balance sheet structures.

And it appears Fannie execs sat down and worked out how to avoid faithful interpretation of FAS 133. The SEC said that Fannie "internally developed its own unique methodology" for assessing whether derivatives losses could be kept out of earnings in the period they occurred. It will now be up to the Justice Department, probing Fannie, to determine who set up and implemented this "unique methodology," and whether it was established with the specific intention of keeping losses out of earnings.

The hubris and greed of the top executive team at Fannie was also Enron-like. A close reading of the numbers shows that the company was run by aggressive risk takers who wanted to make large bets to ensure the company hit the earnings targets given to Wall Street. Particularly in 2002, Raines and his top managers left the team without anywhere near enough protection againstadverse moves in interest rate moves. When the derivatives losses piled up as a result, the misapplication of FAS 133 very conveniently meantthat Fannie didn't have to book those losses through earnings.Detox

warned readers to include the losses in any attempt to value Fannie Mae.

As with many scandal-hit companies, Raines and his team also collected millions of dollars in the form of stock options. The latest stock option award was massive, contributing to Raines' $20 million package in 2003, but there is a good chance that, because of the need to restate numbers, OFHEO will demand Raines repay that sum. The defiant stance taken by Raines in defense of Fannie's accounting before a House committee in October did evoke the infamously aggressive Congressional testimony of Enron's former CEO Jeff Skilling.

Raines defiantly stated before the committee that Fannie's "financial statements were certified by me and by our Chief Financial Officer, Tim Howard, after a thorough process, and audited by our independent auditor, KPMG." And if Raines is Skilling, and Howard a possible Andrew Fastow, does that make KPMG the next Andersen? If the accounting firm is found to have collaborated in a scheme to keep FAS 133 losses out of earnings, the firm will be seriously damaged.

Beltway Blunders

But in some ways the Fannie mess is much worse than any of the big recent corporate scandals. Fannie betrayed public trust on a massive scale. And its decline into a accounting scandal endangers the health of the U.S. housing market. Fannie was set up by a congressional charter to provide liquidity to the housing market. It moved way beyond its main business of guaranteeing mortgages to buying them and holding them on its books. It now has over $900 billion of mortgages on its books.

Politicians of all persuasions should be appalled that a company set up to indirectly help people buy their own home should have gone as far afield as it did. And the scores of legislators who benefited from Fannie's largesse should start to make amends by agreeing to the most stringent reform bill possible for Fannie and Freddie, which was the center of its own, less serious, accounting scandal in 2003.

What are the next steps for Fannie? Raines and his band of pirates will jump ship possibly by the end of this week, leaving the board the task of finding an interim CEO and management team. Given the pervasive influence of Raines within Fannie, it will take a long time to right the culture there.

Capital will have to be raised. Detox

recently calculated that means rasing $11 billion to cover the $9 billion of losses, and making up a 30% capital surcharge imposed in Sept. by OFHEO. Given the massive leverage of Fannie, that could mean selling over $330 billion of mortgages. While it would be tough to offload that amount of mortgages, it's just as hard to see Fannie being able to sell billions of dollars of stock when it's not able to file accurate financial statements with the SEC.

What an absolute mess. Blame for this debacle should be liberally spread around Washington, Wall Street and in Fannie's executive suite. And if it weren't for a couple of savvy short-sellers, OFHEO, a few clear-sighted folk in the Bush administration, and, yes, the press, Fannie would still be going about its main activity for the last five years -- the wholesale destabilization of the U.S. housing market.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to

peter.eavis@thestreet.com.